What is a REIT? A guide to real estate investment trusts

If you’ve wanted to invest in real estate but don’t want to have to manage your property on a day-to-day basis, or hire a property manager to attend to the property for you, a real estate investment trust might be right for you. With a REIT, you can be a real estate investor without owning property or rental units. It’s a more hands-off approach for those who want to grow their wealth through real estate but don’t want to handle the constant upkeep that comes with owning a property.

How do you define a REIT?

REITs own, operate, or provide funds for income-generating properties, like office buildings, shopping centers, apartments, hotels, and warehouses. Unlike traditional real estate businesses, REITs focus on managing and maintaining a property portfolio rather than building properties for sale.

To be a REIT:

• At least 75% of its assets must be in real estate, cash, or government securities.
• At least 75% of its income must come from renting properties, mortgage interest, or property sales.
• At least 95% of total income must come from these real estate sources, along with dividends and interest.
• It needs at least 100 shareholders for at least 335 days of a 12-month tax year, and shares should be freely transferable like regular stocks.
• Five or fewer people can own no more than 50% of the REIT's shares during the last half of the tax year.

What properties do REITs invest in?

Let’s explore some common REIT categories:

• Residential REITs. These are REITs with properties used by residential tenants, such as apartment complexes, single-family residential, and townhouses. They could include student housing and manufactured homes.
• Commercial REITs. These companies buy and run properties where businesses operate. Think about office buildings, coworking spaces, medical buildings, shopping malls, and retail centers. These properties typically generate income through long-term leasing arrangements.
• Health care REITs. These focus on real estate related to medical facilities. They invest in hospitals, nursing homes, retirement communities, and medical centers. Their income depends greatly on changes in health care costs and how full their properties are.
• Industrial REITs. These own and oversee industrial properties like warehouses and distribution centers. They benefit from the increase in online shopping and global supply chains. They usually sign long-term leases with reliable tenants, which helps them stay strong during tough economic times.

How do REITs work?

REITs let people invest in real estate that generates income and experience the benefits of investing in real estate without buying property themselves. These come in a few types. Publicly traded REITs are on stock exchanges, and you can buy and sell them like stocks. Public non-traded REITs aren’t on exchanges but are registered with the SEC. Then there are private REITs, which aren’t registered and are usually available only to big-time investors or those who meet certain criteria.

A REIT usually has a board of directors or trustees who decide on investment strategies. Many REITs also have managers who find properties, handle daily operations, and manage other details. Most REITs make money by charging tenants rent or earning interest from real estate loans. They then give this money to investors, usually in the form of regular dividend payments.

How to invest in REITs

Investing in REITs can be a smart way to earn money from real estate income without owning property. Here’s how you can get started:

1. Learn about the different types of REITs

Before you get started, you should know the various kinds of REITs to understand what you're getting into, both the pros and the cons. For instance, Equity REITs typically earn by renting out properties such as apartments or office spaces. On the flip side, residential mortgage REITs make their income from mortgage payments straight from borrowers, along with the interest they collect.

2. Figure out your investment goals

Think about your financial goals to see if REITs fit into your plan. Stocks might be better if you want higher returns and can handle more risk. REITs aren’t as wild as stocks, but they carry more risk than bonds because the real estate market changes. Think of REITs as a middle ground for risks and rewards.

3. Research REIT investments

Before putting money into any REIT, do your homework. Look at things like past performance, what kind of returns they've given, and any management fees. Always read the REIT's prospectus to know what you’re signing up for and what you’ll be getting into.

4. Choose how you want to invest in REITs

When you decide to put your money into REITs, you need to pick between those you can trade on stock exchanges and those you can't. REITs listed on stock exchanges let you buy and sell through a brokerage account, making it easy to trade. You also get the freedom to trade shares whenever the market is open.

Non-publicly traded REITs are not on stock exchanges and might need a relationship with big investors. They are usually less liquid and come with fewer protections. If you choose this route, make sure you fully understand the risks and how they fit into your bigger investment picture.

5. Keep an eye on your REIT investments

After investing in REITs, keep an eye on how they perform. You don't need to check them every day, but do take some time now and then to see if they still match your goals. Think about how they fit with your other investments. If the market changes or your personal situation changes, you might need to tweak your investments.

Types of real estate investment trusts

There are several types of REITs to consider, each offering unique investment opportunities.

• Equity REITs: These own and manage properties like apartments and office buildings that bring in rent money. They make cash by collecting rent from tenants. After covering expenses, they send most profits to investors as dividends. 
• Mortgage REITs, or mREITs: Mortgage REITs earn money from the interest on mortgages they have. They might create new loans or buy mortgage-backed securities. Their income comes from property owners paying their mortgages. 
• Hybrid REITs: These combine equity and mortgage REITs. They get income from both rents and mortgage interest. Thus, this mix helps spread risk if one part of the real estate market takes a hit. 
• Specialty REITs: These REITs focus on unique properties that don’t fit the other categories. Think amusement parks, movie theaters, or farms. If you want something different from the typical property investment options, this is your area. 

Pros of REIT investing

Putting money into REITs can help you tap into the benefits of passive real estate investing and create new financial opportunities.

• Liquidity: Selling REIT shares is easier than selling a property. If they’re publicly traded, you can sell fast – often within minutes – instead of waiting weeks or months to sell a property. 
• Investment diversification: REITs let you add real estate to your investments without owning physical property. If you have stocks or bonds, this helps balance your investment assets. 
• Dividend income: REITs must give out most of their profits as dividends to keep their tax perks. This means a steady flow of passive income for you. 

Cons of REIT investing

Even though REITs offer some great investment opportunities, they have potential downsides.

• Market risk: When investing in REITs, you face the ups and downs of the real estate market. Things like economic hits, dropping property values, or more foreclosures can hurt your investment. 
• Sensitivity to interest rates: Interest rates affect the real estate market a lot. When rates go up, it can make buying or renting harder. While fixed-rate REITs might offer some shield, rising rates still have a big impact. 
• Management fees: Trustees and fund managers handle REITs, which means they charge fees that can reduce your returns. So, think about these costs when looking at possible investments.

Tax implications of REIT real estate investing

One of the big perks of investing in REITs is that they don't pay income tax if they give back 90% of their revenue to investors after covering costs. This rule makes them a tax-smart choice for investors.

For individual investors, the dividends are taxable. They usually get taxed as your normal income, so the rate varies depending on your tax bracket.

If a REIT decides to sell a property, it must pay a capital gains tax, which can hit up to 20%. Plus, if your modified adjusted gross income crosses certain limits, you'll owe an extra 3.8% on your net investment income.

Here’s the breakdown:

Investing in REITs through a retirement account works a little differently. You won't pay taxes immediately with a traditional 401(k) or IRA. Instead, you’ll be taxed at your regular income rate when withdrawing money after you’ve retired. On the flip side, using a Roth 401(k) or Roth IRA means you won’t owe taxes on withdrawals because you've already handled the tax on contributions.

Chatting with a tax professional is a good idea if you're unsure how REITs will fit into your retirement plan.

Is it worth investing in REITs?

Like any investment, REITs come with risks and tax implications. Before jumping in, consider how much risk you're OK with and your financial goals. Because REITs are sensitive to the stock market and interest rates, their value can swing significantly. Plus, real estate market conditions and property sector trends can affect REIT performance. That's why it's best only to invest what you can afford to leave alone long term.

REITs aren’t meant for quick wins. They tend to work better as long-term investments, giving you more time to ride out market changes. Make sure you’re willing to research the different types – like equity, mortgage, hybrid, or specialty REITs before deciding what’s right for you.

 REITs could be a solid pick if you're ready to invest and want to diversify your portfolio with real estate without owning property.

The bottom line: Learn how to invest in REITs

You can invest in real estate without buying properties or dealing with renters through REITs. These can be bought on stock exchanges, over the counter, or via private investment companies. REITs usually make money through rent collection or mortgage interest, though some use other ways. They tend to rise in value during times of economic growth when demand for real estate increases and rents or property prices go up.

Before diving in, consider how REITs align with your financial goals and overall portfolio. Look into different trusts and keep an eye on your investments regularly. You can also find real estate investing tips here.

You may also want to explore other real estate investment options to find the best fit for you. If you’re unsure, a financial advisor can help.